TOKYO – True or false? That's the puzzling question economists are trying to answer about the uneven recovery now under way in Japan.

They've been fooled before and, so far, the evidence is confusing.

The apparent return to better times, after 12 years of economic doldrums that followed the bursting of the speculative land and stock "bubble," is being driven by exports, primarily automobiles, machinery and steel. Still relatively immune and untouched are smaller companies and retailers dependent on the domestic market.

"Many structural problems remain,” says Mamoru Yamazaki, chief economist-Japan for Barclays Capital Japan. “Excess debt is still depressing the economy. A strong recovery could be five years away."

Much of Japan’s economic outlook hinges on yen’s rate of exchange.

So far, the record is mixed and there are reasons to be optimistic, pessimistic or both.

Unemployment remained at 5.1% in September, down only slightly from the postwar record high of 5.5% set in December 2002, and jobs are hard to find. Deflation continues. In October, wholesale prices fell for the 38th straight month and the Tokyo Consumer Price Index, an indicator of price trends nationwide, declined for a record 49th month.

But bad loans at Japanese banks, still at least $400 billion, finally have begun to shrink. Corporate profits are turning up, bankruptcies are declining and the stock market is showing signs of renewed health.

The brightest light on the economy is shone by exports, to the U.S. and especially to Asian neighbors, up 8.1% to a record ¥28.8 trillion ($254 billion) in the six months ending Sept. 30. However, the unprecedented volume is souring relations with some trading partners and arousing sharp criticism, especially from U.S. leaders, about currency manipulation in Tokyo

In the first 10 months of 2003, Japanese authorities spent ¥16.2 trillion ($145 billion) selling yen and buying dollars in an attempt to weaken their currency. This was more than double the record intervention in 1999. Yet, despite the massive current intervention in the foreign exchange market to help exporters and discourage imports, the yen is strong and becoming stronger.

"The Bank of Japan is very nervous about the strong yen and will continue to intervene," says Yamazaki.

The heavy spending may not be enough. By the end of 2004, HSBC Securities (Japan) foresees Japan's currency strengthening to ¥104:$1, up from about ¥108:$1 at present, and Credit Suisse First Boston Securities (Japan) puts the rate then at ¥103:$1.

The re-election in November of Prime Minister Junichiro Koizumi is not expected to affect the recovery much, if at all.

His Liberal Democratic Party (LDP) once again failed to win a majority in the Diet, where power will remain shared in a coalition.

"The ‘Koizumi myth’ – his Teflon popularity – appears to be diminishing," editorializes the Japan Times.

The election results have increased pressure from the LDP old guard, who oppose Koizumi for rocking their “pork barrel boats,” and raised fresh doubts about his plans for economic reform.

After waiting and watching impatiently since he became prime minister in April 2001, disappointed critics dismiss his promises as mostly talk and little action.

"The ultimate problem today is a widespread refusal to discuss the key issues and thus never to face them," British economist Andrews Smithers says at a recent symposium in Tokyo.

"True reforms have not yet been made," says Yamazaki, "and Koizumi's focus won't change much. Important moves will be absent."

In a semi-annual report released Oct. 31 outlining the medium-term outlook, the Bank of Japan says "the economy will be moving forward at an extremely slow pace," noting that recovery has been limited mainly to large manufacturers, with other companies mired in debt and consumer spending stalled. The report forecasts real growth of 2.3%-2.7% in fiscal 2003, which ends March 31, 2004, and 2%-2.8% in fiscal 2004. Bank of Japan Governor Toshihiko Fukui remains only "cautiously optimistic."

The prime minister is even more cautious. During the election campaign, Koizumi said, "Although some bright spots have emerged belatedly, the economy will not experience a full-fledged recovery for at least three years."

Between now and then, there may well be a little improvement in the domestic automotive market that has matured and shrunk since the good old days of 1990 when sales peaked at 7.77 million units. This year, total sales of cars, trucks and buses are expected to be virtually flat at 5.8 million units.

"Basically, the Japanese market continues to go nowhere. Growth in the economy has not filtered down yet to vehicle sales," says Chris Richter, an industry analyst at HSBC Securities (Japan), adding that any improvement in auto sales here “might be toward more expensive models, not volume."

Seiji Sugiura, an industry analyst with the Nomura Research Institute in Tokyo, is a tad more optimistic about the near-term outlook. He expects flat sales this year to be followed by a modest rise in 2004 to 6 million units and a further rise to 6.4 million units in 2007, most of them to replace aging vehicles currently on the road.

Yet with overseas markets the chief engines of growth and the source of most of their profits, Japanese auto makers understandably are focused more sharply on foreign-exchange rates and wondering where the yen is likely to move and what damage it will do to their bottom lines.

"There will be little yen impact this year, but next year could be troublesome for auto makers,” says Koji Endo, head of Equity Research, Credit Suisse First Boston Securities (Japan). “An appreciation of one yen against the dollar equals 1.5% of their total profits, and against the euro amounts to 0.3% of their profits."

Endo feels auto makers can offset most, if not all, of the negative effects of another ¥5 appreciation with additional cost reductions, price increases and more sales in the U.S., but says "if the yen goes to 100, it will be really serious and a different story."

At this point, anybody is welcome to guess what will happen to the yen-dollar rate of exchange and the same uncertainty clouds the future of Japan's current economic recovery. Will it be sustainable or another false start? Nobody really knows.